Expectations play a key role in modern macroeconomic modelling. Decisions are made not only with the past and present in mind, but also the future. People are aware that central banks control interest rates, even if they are not fully conversant with the economics of central banks. Ask yourself a question, therefore: what do you think the next interest rate move will be in your country? Then consider where you think interest rates will be in two, three and five years’ time. If you think interest rates are going to rise, how far will they increase and at what point do you think they will change direction?
ABCT puts a focus on the role of central banks in business cycles. Assume that the central bank decides to increase interest rates. Firms considering investment projects will now consider whether the project remains viable and, at the margin, whether some projects will be shelved. This leads to a slowdown in the economy. However, firms will also know that at some point in the future interest rates will fall and investment projects will then be undertaken helping to fuel growth. The increasing and lowering of interest rates by the central bank is seen as being ‘artificial’
in that it is not being changed because of imbalances in the demand and supply of loanable funds but because of perceptions of changes in inflation. The artificial changes in interest rates ‘fool’ firms and households into making decisions which generate expansions and contractions in the economy, and hence are a cause of business cycles.
Critics of the ABCT argue that firms and households are not so dumb as to be fooled by interest rate changes, at least not in the longer term, having suffered repeated cycles. After all, few people expected interest rates to remain at historically low levels forever as they were following the Financial Crisis. However, many decisions are not made with the macroeconomy in mind. Individuals, for example, may have taken advantage of lower interest rates by rescheduling their mortgages or borrowing to fund highend purchases such as cars. These individuals act in their own self-interest. Equally, firms will anticipate changes in demand when interest rates change. If rates are lowered, they expect demand to increase and put in place plans to be in a position to expand output in preparation. Again, these firms are acting out of self-interest.
Economic actors respond to short-term changes in economic circumstances not long term. If a family can lower its mortgage payments by rescheduling its mortgage, it makes sense to do so. Equally, firms do not want to be caught out with no spare capacity when demand does increase and lose out to competitors who have prepared with more foresight.
Far from being ‘fooled’, economic actors are fully aware of the likely future direction of interest rates, but that does not stop them from acting in a way which fuels cycles of expansion and contraction. According to some Austrian school economists, it is not economic actors that should shoulder the blame but central banks who intervene in financial markets.
Critical Thinking Questions
1 Why are expectations considered such an important element of macroeconomic analysis?
2 Critics of ABCT argue that economic actors cannot be ‘fooled’ repeatedly. To what extent are economic actors impeded by imperfect information?
3 When interest rates were reduced to almost zero across many developed economies, would you have foreseen that they would have stayed so low for so long? How might your view have affected your decision-making?
4 To what extent do you agree with the ABCT view that central banks are complicit in the creation of business cycles?
5 Of the theories presented in this chapter, which model do you think provides the best explanation of the causes of short-term economic fluctuations and why?